Arnold Kling  

We Don't Know

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Russ Roberts discusses some survey data in which small businesses report that their biggest problem is lack of sales. Some economists have leaped on this as a decisive data point demonstrating that the problem in the economy is aggregate demand, not supply.

I am trying to get away from the paradigm of aggregate demand and aggregate supply. Instead, you might think of an analogy involving the opening and closing of trade routes. If a new trade route opens, there will be new patterns of specialization and more economic activity. If a trade route shuts down, those patterns will be disrupted. Think of a boom as new trade routes opening, and think of a recession as trade routes shutting down. Keep in mind that this is just a metaphor--a trade "route" need not be something physical.

I'll discuss the empirical issue below.

Since I have been promoting the Recalculation Story, many people have been asking for a decisive test of that story versus aggregate demand. I wish I could come up with one. There are lots of bits of evidence that can be construed as supporting one or the other, but nothing that I think is decisive.

I understand that this is very frustrating. It's not that I am anti-empirical. It's just that the controlled experiment is not available to us. What is available to us is fragmentary.

Moreover, I am promoting what I see as a different lens through which to view macroeconomics. It is not that "aggregate spending" and "patterns of sustainable specialization and trade" are mutually exclusive. They are two ways of conceptualizing economic activity, and just about any given observation can be interpreted through either lens.

I continue to believe that our best hope for understanding economic activity is from the new data sets on business dynamics and labor market dynamics. So far, the lessons that I think we can take away from these are:

1. The net job creation numbers are very small relative to the gross flows. Even when the economy is booming, millions of people lose their jobs every month. Even when the economy is floundering, millions of people find jobs every month.

2. Fast-growing firms create most of the jobs. These tend to be young firms, but not necessarily small businesses.

3. Young firms also account for a great deal of job destruction. Young firms tend to die at a high rate.

What does it tell us that in a survey many small businesses say that their biggest problem is lack of sales? Based on my experience as an entrepreneur and talking with other entrepreneurs, I would say that if your biggest problem is not sales, then you are in a relatively comfortable, established position. It is a luxury to be able to complain about taxes or regulation or intellectual property theft or some other problem. Sales are the make-or-break issue for most businesses, certainly for any young business.

From a Recalculation Story perspective, it is possible that what is going on these days is a relatively high rate of formation of weak businesses, by which I mean a business that begins without a sufficient customer base. Such businesses are likely to correctly report that their biggest problem is lack of sales, and such businesses have a high probability of experiencing little growth or outright failure.

The formation of weak businesses rather than strong businesses (if that is what is going on) probably reflects the overall business climate. Many folks on my side of the political fence are ready to blame government and throw around "regime uncertainty" as the reason that businesses are weak today. I was asked to endorse that view last month on a CBC TV program, and I pointedly refused. We don't know. To me, "regime uncertainty" means that you think we might go fascist or Communist, and the likelihood of that seems lower now than at other points in history, even in my lifetime. As much as government may be expanding its reach, I do not believe that policy uncertainty, much less regime uncertainty, is a major factor for the typical entrepreneur.

To me, the overall business climate is difficult because the Great Recalculation exposed some large, established businesses as unsustainable. What many start-ups do is sell to large, established businesses. When the latter are cutting expenses in order to survive, they are not likely to experiment with the offerings of start-ups.

At some point, large businesses will stabilize, and they will start to look for opportunities to reach new markets and achieve new efficiencies. They will increase their purchases from younger companies, and the result will be new patterns of sustainable specialization and trade.

The collapse of mortgage securitization disrupted many trading patterns, in ways that are too complex to trace. For all we know, it may have caused some small manufacturer of agricultural implements to go out of businesses, because those implements were used by farmers to grow some specialty vegetable served on the tables of Manhattan restaurants frequented by securities lawyers.

Going back to the analogy of trade routes, I think that the Internet continues to open up new trade routes. However, the market has not figured out how to best work with those trade routes.

Entrepreneurs are trying to come up with sustainable businesses in today's environment. They are failing at a high rate. At some point, enough entrepreneurs will achieve enough successes to bring about full employment.

That is the way the economy looks from a Recalculation Story perspective. I wish that there were some decisive empirical evidence that could tell you to use that perspective rather than the Keynesian perspective. However, I do not think the issue is going to be settled with a single data point.

Again, I do not want to be backed into making the choice "aggregate demand or aggregate supply." Instead, my guess is that if the Recalculation Story gains traction, it will be because people start to look at the JOLTS data and the business dynamics data from the standpoint of the creation and destruction of patterns of sustainable specialization and trade, and in doing so they lose interest in the distinction between aggregate demand and aggregate supply.


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COMMENTS (15 to date)
fundamentalist writes:
many people have been asking for a decisive test of that story versus aggregate demand.

How some empirical evidence for the AD/AS story? In fact, how about a real explanation? A fall in AD does not cause depressions; it is a description of a depression. It's amazing to me that Keynesians can't tell the difference between a cause and a description. Of course AD falls in a depression; it is the depression! What we need is an explanation for the fall in AD. The recalc story provides one. For empirical data, look at unemployment rates in different industries. You'll find that unemployment in capital goods producing industries is always much higher in depressions than unemployment in consumer goods producing industries.

Yancey Ward writes:

"My biggest problem is that no one wants to buy what I am selling." This is the lament of every unsuccessful businessperson and/or laborer. What does it mean when you hear this? It means there are unsuccessful business people and laborers.

Thomas Sewell writes:

"regime uncertainty" means to me that business doesn't know what to expect. Entire sectors of the economy may be semi-nationalized like automotive or health care or shut down like off-shore drilling.

Taxes may go up, or they may not. Regulations may increase, or they may stay the same. Who knows? Who can even guess?

If your business decisions depend on any of these factors, at the margin decision makers are going to "pay it safe" and limit their risk exposure to these kinds of activities.

That translates to limiting expansion because of uncertainty. There is a reason the stock marker tends to go up at least a little after elections, no matter who wins. The uncertainty factored into the prices has been reduced.

Bill N writes:

The unfortunately named "Chaos Theory" relies on a deterministic assumption. The theory is deterministic, but not calculable over extended time or space. The components must have well defined properties, behaviors and interactions. The emergent aggregate properties can be quite surprising. Think of weather systems or the computer "game of life". Any uncertainty or change in the underlying rules will change system behavior. Sustained order cannot emerge without sufficient rule stability.

Tyler In Chicago writes:

Would it be fair to say the the Recalculation Story is an AD problem for 'bypassed' firms at the micro-level? After all, if I was building houses on spec in Nevada a few year ago I'd be experiencing a huge decline in sales right now ....

Aaron writes:

Tyler,

Can there be an "AD" problem for individual firms at the micro level? It seems like that would just be a regular old demand problem...

Lord writes:

The reason sales are hard to come by, the reason unemployment is high, the reason there is uncertainty, is tight money. When everyone has to cut expenses, save for the dismal future and here and now, no one will have much success, no one will expand, no one will hire, and no one will know what to do next. That is what we have. When an industry fails, others must take up the slack, and when such a large diverse industry fails, many others must take up the slack, but they cannot do this unless their profits rise and that is precisely what the Fed is responsible for, and their failure to do so is caused by.

Silas Barta writes:

"Thank you for your analysis, Mr. Kling. We will make sure that government policy injects an appropriate counterbalancing level of trade routes into the economy. (Metaphorical trade routes, of course; we're not idiots.)"

-- Mainstream Economist

BZ writes:

@Lord: Is that aggregate tightness?

hacs writes:

What is the time series for the number of small businesses?

Thomas DeMeo writes:

The goal is to come up with policy prescriptions. Identifying the problem as aggregate demand seems to be designed to give the government permission to take steps to pump that demand.

While a recalculation of patterns of sustainable specialization and trade may be a better way to describe the problems at hand, I'm not sure what can be done with such an insight. I think looking at the buildup of the reciprocal is probably more useful to look at, where we look at why organizations stay caught in patterns of unsustainable specialization and trade when the better way is fairly obvious. This is usually because the recalculation would cause great damage.

If we could just start over, new patterns would click into place fairly cleanly. As it is today, we have gridlock. What policy prescriptions would help firms untangle, so they could recalculate more quickly?

Bill N writes:

The unfortunately named "Chaos Theory" relies on a deterministic assumption. The theory is deterministic, but not calculable over extended time or space. The components must have well defined properties, behaviors and interactions. The emergent aggregate properties can be quite surprising. Think of weather systems or the computer "game of life". Any uncertainty or change in the underlying rules will change system behavior. Sustained order cannot emerge without sufficient rule stability.

kurt writes:

My hunch is that small business are likely to lay off people and larger businesses are likely to hire new people, just because of economies of scale. And if Krugman wants to talk about 'aggregate demand', he should be looking at large businesses anyways, since comparatively speaking, they employ the most people and have the most receipts (http://www.census.gov/econ/susb).

R Richard Schweitzer writes:

It has been 59 years since I walked out of my last classes in graduate Econ at U.Va; taking with me no sentiments for AD/AS theories.

We recognize that supply does not arise solely from "Demand." As was said back then, nobody was "demanding" an incandescent light bulb.
Today, nobody was demanding the broad scope of techological innovations and resulting gadgets (current and obsolete).

But, where real demands (needs) exist, it is more important to ascertain the forces that generate those demands, by some categories or classifications and determine the effects of those demands on the transactions within our "economy."

That is one reason for the focus on residential housing - the forces and factors appear obvious, as do the transactional effects. But to introduce artificial or contrived factors into that demand equation, or into any demand equation will sooner or later breakdown the natural transactional effects - just as would artificially increasing supply, say of housing.

Thus, today, the measures of AD/AS are defective because of interventions of many kinds into basic disparate demands.

fundamentalist writes:

Dr. Kling, I would really like your take on this statement on the state of economics and how to fix it by David Colander: http://www.coordinationproblem.org/2010/09/read-and-react-colanders-testimony-on-capitol-hill-about-economics.html

It is his testimony before Congress. Here is an excerpt:

"What I mean by this is that when, over drinks, I have pushed macroeconomic researchers on why they focused on the DSGE model, and why they implied, or at least allowed others to believe, that it had policy relevance beyond what could reasonably be given to it, they responded that that was what they believed the National Science Foundation, and other research support providers, wanted. That view of what funding agencies wanted fits my sense of the macroeconomic research funding environment of the last thirty years. During that time the NSF and other research funding institutions strongly supported DSGE research, and were far less likely to fund alternative macroeconomic research. The process became self-fulfilling, and ultimately, all macro researchers knew that to get funding you needed to accept the DSGE modeling approach, and draw policy conclusions from that DSGE model in your research. Ultimately, successful researchers follow the money and provide what funders want, even if those funders want the impossible. If you told funders it is impossible, you did not stay in the research game."
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